What is an Operational Risk?

Operational risk is the risk associated with a company’s business operations. It encompasses a wide variety of risks, including fraud, legal, financial or environmental issues. Certain business industries may be more prone to these risks, depending on the type of business operations and the amount of government regulation in the business industry or sector. Operational risk is not a market-wide or industry risk; companies are usually unable to diversify this risk by changing or limiting its business operations. Risk management or avoidance is a driving force for managers making decisions about their company.

All companies use a form of risk management when conducting business operations or entering new business industries or sectors. Managers may decide to create standard operating procedures or internal controls for employees to follow when working in the business. These standards and procedures can help the company limit the operational risk associated with its production or service processes. Companies will also develop other safeguards for limiting this risk in other areas of its business functions.

Financial risk is another important part of operational risk. Financial risk usually involves the monetary and accounting side of businesses. This may be the most important operational risk faced by companies. The inability to generate a positive cash flow or secure outside funding from lenders or equity investors may limit the company’s growth and expansion opportunities. Companies employ traditional corporate finance formulas and management tools to help managers understand how well their company is doing financially. Setting aside a part of net income can help companies create a buffer when planning for potential financial problems.

Legal and environmental risks are two types of external operational risk. Legal risk involves the company facing lawsuits from employees or consumers regarding internal working conditions or dangerous products and inadequate services. Employees facing hostile workplace conditions or unfair wage practices may seek legal aid to rectify these situations. Consumers injured from a company’s product or service is common forms of operational risk. In addition to these operational risks, companies usually have an obligation to protect the environment when conducting business operations.

Environmental risks can encompass several types of operational risks. Protecting wildlife, rivers and lakes or other natural resources can help companies limit its exposure to this type of operational risk. Companies failing to properly avoid this risk may be subject to federal, state or local fines and restrictions. Companies may also be required to clean up any environmental issues they have created, quickly taking the environmental risk to a potentially major financial risk.